Practice Exam1 Solution Bank Management

Solution of Practice Exam 1 1. Which of the following is not a major function of financial intermediaries? A) Brokerage services. B) Asset transformation services. C) Information production. D) Management of the nation's money supply. E) Administration of the payments mechanism. Answer: D 2. Asset transformation consists of A) receipt of securities across electronic payments systems. B) altering the liquidity and maturity features of funds sources used to finance the FI's asset portfolio. C) granting loans to transform funds deficit units into funds surplus units. D) None of the above. E) All of the above. Answer: B 3. Regulation of FIs is A) minimal, as evidenced by the recent thrift debacle. B) extensive, as a result of the importance of FI to the state of the economy. C) minimal, because the free market is allowed to allocate financial resources. D) extensive, because banks have monopoly power. E) no different from regulation of nonfinancial firms. Answer: B 2. In its role as a delegated monitor, the FI a. keeps track of required interest and principal payments. b. works with financially distressed borrowers in danger of defaulting on their loans. c. holds portfolios of loans. d. maintains contact with borrowers so as to ensure that loan proceeds are utilized for intended purposes. e. All of the above. Answer: E 5. The charter values of FIs will be higher if regulators A) increase the cost of entry by requiring more capital. B) restrict the number of activities permitted by FIs, thereby increasing potential profits. C) restrict the number of FIs that can operate in a given market. D) Answers a and b E) Answers a and c 1-1

Answer: E 6. In a world without FIs, households will be less willing to invest in the corporate sector because A) they are not able to monitor the activities of the corporation more closely than FIs. B) they prefer to invest in longer term securities. C) they are subject to price risk on the sale of securities. D) Answers a and b E) Answers a and c Answer: E 7. National-chartered commercial banks are regulated by A) the FDIC only. B) the FDIC and the Federal Reserve System. C) the Federal Reserve System only. D) the FDIC, the Federal Reserve System, and the Comptroller of the Currency. E) the Federal Reserve System and the Comptroller of the Currency. Answer: D 8. Money center banks are considered to be any bank who A) has corporate headquarters in either New York City, Chicago, San Francisco, Atlanta, Dallas, or Charlotte. B) is a net supplier of funds on the interbank market. C) relies almost entirely on wholesale and borrowed funds as sources of liabilities. D) does not participate in foreign currency markets. E) is not characterized by any of the above. Answer: C I. copay II. deductible III. policy limit IV. safe driver credit V. credit score 9. Among the above, what do insurance companies use to solve the moral hazard problem? A) I, II, and III B) I, II, III and IV C) I, II, IV and V D) I, II, III, and V E) I, II, III, IV and V Answer: B 1-2

d. deposit insurance, open market operations, and discount window borrowing. e. deposit insurance protection. 15 Why is the failure of a large bank more detrimental to the economy than the failure of a C large steel manufacturer? a. The bank failure usually leads to a government bailout. b. There are fewer steel manufacturers than there are banks. c. The large bank failure reduces credit availability throughout the economy. d. Since the steel company's assets are tangible, they are more easily reallocated than the intangible bank assets. e. Everyone needs money, but not everyone needs steel. 16 This is true of off-balance-sheet activities. D a. They involve generation of fees without exposure to any risk. b. They include contingent activities recorded in the current balance sheet. c. They invite regulatory costs and additional “taxes”. d. They have both risk-reducing as well as risk-increasing attributes. e. The risk involved is best represented by notional or face value. 17. What is the defining characteristic of the dual banking system? B a. Coexistence of parent and holding companies. b. Coexistence of both nationally chartered and state chartered banks. c. Control of nationally chartered and state chartered banks by the state regulators. d. Control of nationally chartered banks by both FRS and State bank regulators. e. Nonbanking companies carrying out both banking and other activities. 18. The repricing gap does not accurately measure FI interest rate risk exposure because D a. FIs cannot accurately predict the magnitude change in future interest rates. b. FIs cannot accurately predict the direction of change in future interest rates. c. accounting systems are not accurate enough to allow the calculation of precise gap measures. d. it does not recognize timing differences in cash flows within the same maturity grouping. e. equity is omitted. 1-4

19. A positive gap implies that an increase in interest rates will cause a(n) _____in net C interest income. a. no change b. decrease c. increase d. an unpredictable change e. either a or b 20. When an FI mismatches the maturities of its assets and liabilities, it is exposed to E a. credit risk. b. systematic risk. c. unsystematic risk. d. operating risk e. interest rate risk. 21. What does a bank’s negative gap positions reveal about the bank management's B interest rate forecasts and the bank's interest rate risk exposure? a. The bank is exposed to interest rate decreases and positioned to gain when interest rates decline. b. The bank is exposed to interest rate increases and positioned to gain when interest rates decline. c. The bank is exposed to interest rate increases and positioned to gain when interest rates increase. d. The bank is exposed to interest rate decreases and positioned to gain when interest rates increase. e. Insufficient information. 22. A bank that finances long-term fixed-rate mortgages with short-term deposits is exposed E to a. increases in net interest income and decreases in the market value of equity when interest rates fall. b. decreases in net interest income and decreases in the market value of equity when interest rates fall. c. decreases in net interest income and increases in the market value of equity when interest rates increase. d. increases in net interest income and increases in the market value of equity when interest rates increase. e. decreases in net interest income and decreases in the market value of equity when interest rates increase. 23. Regarding a FI with a positive maturity gap, which of the following statements is true? C a. An increase in interest rates will benefit the FI since the increase in the market value of assets will be greater than the increase in the market value of liabilities. b. An increase in interest rates will harm the FI since the increase in the market value of assets will be greater than the increase in the market value of liabilities. c. An increase in interest rates will harm the FI since the decrease in the market 1-5

2 Y GAP = ( 150 + 150 + 100 + 50 ) − 340 = 110 b. What is the impact over the next three months on net interest income if interest rates on RSAs increase 50 basis points and on RSLs increase 60 basis points? ∆ NII = RSA ∗ ∆ I R RSA − RSL ∗ ∆I R RSL = 300 ∗ .005 − 340 ∗ .006 =− .54 mil . c. The following one-year runoffs are expected: $10 million for two-year T-notes and $15million for eight-year T-notes. What is the one-year repricing gap? 1 Y GAP = ( 150 + 150 + 50 + 10 + 15 ) − 340 = 375 − 340 = 35 d. If runoffs are considered, what is the effect on net interest income at year-end if interest rates on RSA rise 50 basis points and on RSL increase 75 basis points? ∆ NII = RSA ∗ ∆ I R RSA − RSL ∗ ∆I R RSL = 375 ∗ .005 − 340 ∗ .0075 =− .675 mil 2. County Bank has the following market value balance sheet (in millions, annual rates). All securities are selling at par equal to book value. Assets Liabilities and Equity Cash $50 Demand deposits $120 15-year commercial loan @ 10%, $200 5-year CDs @ 6% , $250 30-year Mortgages @ 8% , $400 20-year debentures @ 7% , $200 Equity $80 Total Assets $650 Total Liabilities & Equity $650 a. What is the maturity gap for County Bank? 1. MA = 50 650 ∗ 0 + 200 650 ∗ 15 + 400 650 ∗ 30 = 4.6154 + 18.4615 = 23.0769 yrs 2. TL = 120 + 250 + 200 = 570 ML = 120 570 ∗ 0 + 250 570 ∗ 5 + 200 570 ∗ 20 = 2.193 + 7.0175 = 9.2105 yrs 3. Maturity GAP = MA − ML = 23.0769 − 9.2105 = 13.8664 yrs 1-7

b. What will be the maturity gap if the interest rates on all assets and liabilities increase by 2 percent? 1. MV of 15 yr loan = FV = 200 , PMT = 20 ,N = 15, I Y = 12 ,CPT PV = 172.76 MV of 30 yr mortgage = ( 1 ) PV =− 400 ,FV = 0 ,N = 30 ∗ 12, I Y = 8 12 ,CPTPMT = 2.9351 MV of 30 yr mortgage = ( 2 ) PMT = 2.9351 , N = 360 , FV = 0, I Y = 10 12 ,CPT PV = 334.46 MV of TA = 50 + 172.76 + 334.46 = 557.22 = 557 2. MV of CD = PMT = 250 ∗ 6% = 15, N = 5 , FV = 250, I Y = 8 ,CPT PV = 230.04 MV OF DEBT = PMT = 200 ∗ 7% = 14, N = 20 , FV = 200, I Y = 9 ,CPT PV = 163.49 MV OF TL = 120 + 230 + 163 = 513 3. MA = 0 + 172.76 557 ∗ 15 + 334.46 557 ∗ 30 = 4.6524 + 18.014 = 22.6664 ML = 0 + 230 513 ∗ 5 + 163 513 ∗ 20 = 2.2417 + 6.3548 = 8.5965 4. MGAP = MA − ML = 22.6664 − 8.5965 = 14.0699 YRS c. What will happen to the market value of the equity? MV OF TE = MV OF TA − MV OFTL = 557 − 513 = 44 3. Suppose you purchase a five-year, 15 percent coupon bond (paid annually) that is priced to yield 9 percent. The face value of the bond is $1,000. a. Show that the duration of this bond is equal to four years. Five-year Bond Par value = $1,000 Coupon rate = 15% Annual payments R = 9% Maturity = 5 years N = 5 PMT = 150 FV = 1000 I/Y = 9 CPT PV = 1233.38 D = 150 ∗ 1 1.09 + 150 ∗ 2 1.09 2 + 150 ∗ 3 1.09 3 + 150 ∗ 4 1.09 4 + 1150 ∗ 5 1.09 5 1233.38 = 3.97 ≈ 4 ( yrs ) b. Show that, if interest rates rise to 11 percent within the next year and that if your investment horizon is four years from today, you will still earn a 9 percent yield on your investment. (1) Proceeds from bond sale at the end of yr 4: PMT=150, N=1, I/Y=11, FV=1000, PV=1036.036 (2) FV of coupons payments: 1-8

5. A corporate bond has a 8% coupon rate with annual coupon payments, 5 years of maturity, currently selling at par. a. what is the duration of this bond? (4 points) D= [ 80 1.08 + 80 × 2 1.08 2 + 80 × 3 1.08 3 + 80 × 4 1.08 4 + ( 80 + 1000 ) × 5 1.08 5 ] / 1000 =4.312 b..What will be the estimated bond price volatility using duration based estimation formula, if interest rates increase 0.5%? ∆ P P ≈ -D × ∆ R 1 + R ≈ -4.312× 0.005 1.08 = -2% c. What will be the bond price volatility using bond price volatility equation, if interest rates increase 0.5%? Compare the result with the estimated percentage change in the bond price in part b. PMT=80, I/Y=8.5, N=5, FV=1000, PV=980.30 %∆PB= 980.3 − 1000 1000 = -1.97% Diff=-2%−(-1.97%)= -0.03% 6. The two-year Treasury notes are zero coupon assets. Interest payments on all other assets and liabilities occur at maturity. Assume 360 days in a year. A s s e t s : L i a b i l i t i e s : $ 3 0 0 m i l l i o n 3 0 - d a y T r e a s u r y b i l l s $ 1 , 1 5 0 m i l l i o n 1 4 - d a y r e p o s $ 5 5 0 m i l l i o n 9 0 - d a y T r e a s u r y b i l l s $ 5 6 0 m i l l i o n 1 - y e a r c o m m e r c i a l p a p e r $ 7 0 0 m i l l i o n 2 - y e a r T r e a s u r y n o t e s $ 2 0 m i l l i o n e q u i t y $ 1 8 0 m i l l i o n 1 8 0 - d a y m u n i c i p a l n o t e s a. What is the duration of the assets? (4 points) 1-10

TA = 300 + 550 + 700 + 180 = 1730 D A = 300 1730 ∗ 30 360 + 550 1730 ∗ 90 360 + 700 1730 ∗ 2 + 180 1730 ∗ 180 360 = 0.0145 + 0.0795 + 0.8092 + 0.0520 = 0.9552 b. What is the duration of the liabilities? (4 points) TL = 1150 + 560 = 1710 D L = 1150 1710 ∗ 14 360 + 560 1710 ∗ 1 = 0.0262 + 0.3275 = 0.3537 c. What is the leverage-adjusted duration gap? (2 points) LADG = D A − D L k = 0.9552 − 0.3537 ∗ 1710 1730 = 0.6056 d. What is the forecasted impact on the market value of equity caused by a relative upward shift in the entire yield curve of 0.85 percent? (4 points) ∆ E = − ( D A − D L k ) ∗ ∆R 1 + R ∗ A =− 0.6056 ∗ 0.0085 ∗ 1730 =− 8.9052 ( mil ) 1-11